Junior Debt
Junior debt, also known as subordinated debt, refers to loans or securities that rank lower than other loans or securities with regard to claims on assets or earnings. Junior debt is the opposite of senior debt, which has a higher priority in the case of the borrower’s liquidation.
In the event of bankruptcy, the borrower must repay senior debt first. Only after all senior debt obligations are satisfied can holders of junior debt be repaid. This means that junior debt carries more risk for the lender or investor, which is usually compensated by a higher interest rate compared to senior debt.
Common types of junior debt include unsecured loans, subordinated debentures, and bonds. These types of debt can be found on the balance sheet of the borrower and in its capital structure. Junior debt is often used by companies as a way to raise capital for various business purposes, such as funding operations or undertaking new projects.
Example of Junior Debt
TechCorp, a technology company, is looking to raise capital. To do so, it decides to issue $1 million in senior debt in the form of corporate bonds and $500,000 in junior debt as unsecured loans.
Over time, despite their best efforts, TechCorp encounters financial difficulties and ultimately files for bankruptcy. As part of the liquidation process, the assets of TechCorp are sold and the proceeds are used to repay its creditors.
However, the proceeds from the liquidation are only enough to pay back $1.2 million. According to the terms of the debt agreements, the senior debt holders are repaid first. They are paid back the full $1 million that is owed to them. After this repayment, there’s only $200,000 left.
The holders of the junior debt, which is subordinated to the senior debt, are then repaid. However, because there’s only $200,000 left and they were owed $500,000, the junior debt holders only receive 40 cents back for each dollar they lent to TechCorp. This is a loss they must bear because of the higher risk associated with holding junior debt.
This is a simplified example, but it illustrates the fundamental risk and repayment structure of junior and senior debt.
